My Corner post from last Wednesday — pointing out that government “stimulus” spending does not add new purchasing power to the economy because the government must first borrow that purchasing power out of the economy — caused a stir among liberal bloggers Brad DeLong, Matt Yglesias and Stan Collender. Their posts suggest they likely didn’t actually read the report I linked to — which anticipated and answered their counterarguments.

Brad DeLong predictably relied more on insults than analysis. Eventually, he asserted that my point that government “stimulus” cannot alter short-term demand must be false, since it would also mean that demand (and therefore income and spending) must always be fixed, making economic growth impossible. But this ignores that demand growth can come from sources other than fiscal policy.

Recovering from a recession requires first correcting the imbalances that caused the recession. Thereafter, economic growth is a function of productivity and labor supply. Rather than raising immediate productivity or labor supply, government spending (and tax rebates) typically redistributes existing demand from one group of people to another. This is zero-sum.

Yet demand can still grow other ways. Demand is nothing more than purchasing power, which is a function of goods and services provided and sold. Income, by definition, results from productive activity. When productivity increases (thus increasing employment and eventually wages), income increases and demand increases, all in tandem. So the key to increasing demand is to allow the economy to correct its imbalances and then to encourage productivity and labor supply.

Matt Yglesias argued that, during a recession, government spending can put unused resources to work. The problem is that, even in a recession, the spending must be financed by borrowed dollars that would have otherwise been employed elsewhere in the economy. Congress can borrow $10 million from the residents of Anytown to re-open an idle factory in Flint, Michigan. But this leaves Anytown’s residents with $10 million less to spend, which (by the same logic) will cause the idling of resources there. So rather than create new economic activity and multiplier effects, the stimulus has merely transferred them to a new town (my report covers the case of foreign borrowing as well).

Stan Collender asserted that people and businesses aren’t spending their money, so Congress can increase demand by transferring it from “savers” to “spenders.” This argument — which I dealt with at length in my report — ignores the existence of the financial system. Savings do not drop out of the economy. Nearly all people invest their savings, or put it in banks, which lend it out to others to spend. Thus, the financial system transfers one person’s savings to someone else who can spend it. The only savings that drop out of the economy are those hoarded in mattresses and safes.

Collender may contend that recession-weary banks are hoarding savings well beyond the legal minimum reserves. Yet even when banks hesitate to lend their deposits, they invest them in Treasury bills to keep them circulating through the economy and earning interest. In fact, the federal funds market — where banks lend each other any excess cash at the end of the day — exists because banks refuse to sit on unused cash even overnight. Thus, even in recessions, one person’s savings quickly finance another person’s spending.

Yes, we hear about “excess reserves” in the banking system. But those aren’t customer deposits being hoarded in massive bank vaults. Rather, they represent a glut of new dollars held at that Federal Reserve that have not yet been injected into the economy. Held at the Fed, those reserves are not financing the stimulus (more here and here).

Stimulus spending advocates like Collender must be able to show that nearly all the money lent to Washington would have otherwise sat idle in mattresses and bank safes (where it could not be consumed, invested, or deposited in banks for investment spending). Otherwise, Washington is merely a middleman transferring purchasing power from one part of the economy to another — and the justification for government spending as stimulus collapses.

Cross-posted at The Corner.